simmons et al - 2009 - mandatory audit firm rotation - evidence from illinois state universities [mafr]

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MANDATORY AUDIT FIRM ROTATION:
EVIDENCE FROM ILLINOIS STATE UNIVERSITIES
Trisha N. Simmons, Southern Illinois University Edwardsville
Michael L. Costigan, Southern Illinois University Edwardsville
Linda M. Lovata, Southern Illinois University Edwardsville
ABSTRACT
A component of the Sarbanes-Oxley Act required the GAO to survey financial statement stakeholders
to evaluate the key issues regarding mandatory audit firm rotation. The State of Illinois legislates that all
government agencies change auditors every six years. This unique environment provides the opportunity to
investigate audit behavior given mandatory audit firm rotation. This research analyzes audit findings using
the sample of all Illinois state universities governed by the Illinois Auditor General’s audit firm rotation
program. By examining a mandated audit firm rotation program, new evidence is obtained to add to this
debate.
The results of this research indicate that more audit findings are reported in the first year under the
new auditor. It may be that a fresh look initiates different audit findings or that auditors are more rigorous
in the first year of an audit. Also, the fewest number of findings are reported in the last year of the audit prior
to mandatory audit firm rotation. This suggests that either the auditor is less diligent in the last year or that
over the course of the auditor’s tenure, the university was able to correct prior audit findings. Finally, there
is evidence that findings increase with the new auditor, which contradicts the proposition that the university
has improved all of its systems and supports the idea that a fresh look is provided by the new auditor.
Regardless of the interpretation, audit results differ over the course of the mandated audit cycle. More
research is needed to determine the specific reasons for these differences.
INTRODUCTION
This paper examines auditor’s findings when audit firm rotation is predetermined and mandated.
Section 207 of the Sarbanes-Oxley Act of 2002 commissioned the General Accounting Office (GAO) to
conduct a study of audit firm rotation. That report, issued in November of 2003, identified strengths and
weaknesses of mandatory audit firm rotation as specified by the various constituencies, but made no specific
recommendations. Instead, it suggested that the SEC monitor the effectiveness of other provisions of SOX
and revisit the role of mandatory audit firm rotation at a later date if necessary.

The State of Illinois requires all of its agencies to be audited annually by the Illinois State Auditor
General who hires special assistant auditors. The special assistant auditors are external, independent certified
public accountants who conduct financial and compliance audits of the state agencies. By law, each agency
must change special assistant audit firms every six years. This provides a unique opportunity to investigate
the behavior of auditors in a mandatory audit firm rotation environment.
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The State of Illinois issues a report summarizing the results of the financial audit including the
number of findings, the number of repeat findings, and a brief description of the most significant findings.
Data for fiscal years ending June 30, 1994 through 2005 from these Report Digests were obtained from the
Illinois Office of the Auditor General for each of the nine Illinois state universities. There were thirteen full
audit cycles to compare amongst the nine universities.
The number of audit findings throughout the audit firm rotation cycle is investigated. In general,
auditors have more audit findings in the first year of the audit and the least number of findings in the final
year. When the new auditor is appointed, the number of findings again increases. This suggests that audit
findings differ within the rotation cycle.
This paper is organized as follows. First audit firm rotation will be examined and the hypotheses are
developed. Next, a summary of the Illinois State Audit Act is presented. This is followed by a description
of the sample, the results, and then our final conclusions.
AUDIT FIRM ROTATION
Audit firm rotation has been debated for decades as a possible solution to auditor independence
problems (Blough, 1951; Seidman, 1967; the Metcalf Report (US Senate,1977)). Most recently, the
Sarbanes-Oxley Act required the Comptroller General to conduct a study of the potential effects of mandatory
rotation of auditing firms, bringing audit firm rotation once again to the forefront. In November, 2003, the
GAO submitted its report to the Senate Committee on Banking, Housing, and Urban Affairs and the House
Committee on Financial Services. The GAO report synthesized the views of proponents and opponents of
mandatory audit firm rotation that have been consistently debated for almost a century. The 5 main arguments
are summarized in Table 1.
Table 1: GAO’s Summary of Arguments Regarding Audit firm rotation
Proponent’s argument Opponent’s counter argument

Long-term relationships increase audit risk failures Short-term relationships increase audit risk
Increases Public Confidence Cost Exceeds Benefit
Non-U.S. companies require audit firm rotation Non-U.S. countries still have audit failures
Creates a fresh look at the company’s audit The PCAOB provides a fresh look
Creates a competitive market for audit firms Reduces available firms capable of providing service
The conflict between the two sides centers for the most part on the quality of the audit services
provided. Proponents argue that entrenchment will result in audit quality declining as audit tenure increases.
Opponents of audit firm rotation argue that the familiarity with the client increases audit quality. The GAO
report surveyed auditors, corporate accountants, and audit committee members. The results of the study
indicated that no group supported audit firm rotation. In general, it was felt that the costs would exceed
possible benefits. Additionally, they perceived the potential audit problems in the early years of an audit as
being more significant than the probability of an audit failure related to increased audit tenure. The
stakeholders responded that they did not feel the comfort level of the auditor nor the familiarity of the client
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with audit procedures would increase the likelihood of an audit failure. Conversely, the unfamiliarity with
the client’s operations in early years was cited as a potential problem that could result in increased audit risk.
The results of the survey led the GAO to the conclusion that:
We believe that mandatory audit firm rotation may not be the most efficient way to enhance
auditor independence and audit quality considering the additional financial costs and the
loss of institutional knowledge of a public company’s previous auditor of record. (page 8,
GAO)
Not only was the Committee concerned with the cost/benefit tradeoffs of audit firm rotation, but they
also took into consideration the new requirements of SOX. Several of the SOX requirements were designed
to enhance auditor independence and quality, so the Committee’s final observation was:
. . . we believe that more experience needs to be gained with the act’s requirements.
Therefore, the most prudent course at this time is for the SEC and the PCAOB to monitor
and evaluate the effectiveness of the act’s requirements to determine whether further
revisions, including mandatory audit firm rotation, may be needed to enhance auditor
independence and audit quality to protect the public interest. (page 5, GAO)

Given this renewed focus on audit firm rotation, several academic studies have been conducted to
examine audit firm tenure, generally focusing on audit quality defined in various ways. Deis and Giroux
(1996, 1992) investigate the relationship among audit fees, audit hours, auditor tenure, and audit quality for
audits of Texas school districts. In Texas, the State issues a quality control review of the school district’s
auditors and analysis of these letters provides their measure of quality. They find that auditors provide higher
quality audits in the first two years of the audit. They restrict their sample to small, local auditing firms.
Jennings, et. al. (2006) examine the perception of auditor independence and legal liability. Judges
were given scenarios involving audit partner rotation or audit firm rotation. In addition, levels of corporate
governance were manipulated. Judges perceive that audit firm rotation increases independence. In addition,
it interacts with corporate governance. If corporate governance is strong, there is little difference in the
perceived liability of the auditor if a fraud is detected. On the other hand, if corporate governance is
minimally compliant, then firm rotation greatly reduces the perceived liability of the auditor. Taken together,
then, these two studies support audit firm rotation.
A second line of research on audit tenure uses discretionary accruals to proxy for audit quality. These
tend to find higher audit quality in the later years of the audit. Myers, et. al., (2003) examine over 2,600 firm-
years and control for firm size, industry, and growth. They find that higher audit quality (lower discretionary
accruals) is associated with longer auditor tenure. In addition, less extreme accruals are associated with
longer auditor tenure. This would discount the proponent’s view that audit risk increases with the longer term
relationship. These results are confirmed in a study by Johnson, et. al. (2002) that looks more specifically
at the break points in the quality/tenure relationship. They use the absolute value of unexpected accruals and
the persistence of accruals. They partition their sample of over 11,000 firm-years into those with auditor
tenures of 1-3 years, 4-8 years, and 9 or more years. They find that earnings quality is reduced with shorter
audit tenures, confirming the results of Myers, et. al. (2003). There is no significant difference between the
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medium and long-term audit groups. Finally, Gul, et. al. (2007) find an interaction among auditor tenure,
independence, and size. Using a sample of over 4,700 firms, they determine that clients with shorter auditor
tenures again reported more positive discretionary accruals but this is also associated with more nonaudit fees
paid to the auditor. This result is especially significant for small audit clients.
All of these prior studies examined situations where auditor change is voluntary. While some studies

examine mandatory auditor changes in the case of audit firm discontinuation (Nagy, 2005; Reed, et. al.,
2007), the current study examines a scenario where audit firm rotation is dictated at the time the engagement
is initially accepted. This is more in line with what Congress and the GAO report were suggesting. By
examining this sample, we are able to contrast the issues raised by auditors in the early years of the audit and
well as what happens in the final year when the audit firm knows it can not be retained in the future. Also,
unlike the prior studies, the number of audit findings is the dependent variable. This is similar to the Deis and
Giroux (1996, 1992) metric and is a more direct measure of audit results than discretionary accruals.
RESEARCH QUESTIONS
One main argument against mandatory audit firm rotation is that there is a significant learning curve
for each client. Therefore, in early years, the auditor will not be as effective as in later years. Proponents of
audit firm rotation argue that the fresh eyes that the auditor brings to a new audit will enhance audit
effectiveness. The results of prior research are mixed.
In later years, opponents to audit firm rotation suggest that audit effectiveness will be enhanced as
the audit firm becomes more experienced with the client’s operations. Alternatively, proponents of rotation
argue that auditor independence is compromised as the auditor becomes more entrenched and the client
becomes more familiar with the audit processes. No study has been conducted where the change is mandatory
and predictable, so it is unclear what will happen in later years, so again, a direction is not hypothesized.
Therefore, the first hypothesis does not suggest a direction. Instead, we hypothesize that the number
of audit findings differs over the course of the audit cycle. In addition, if the auditor becomes complacent
in later years and/or the new auditor focuses on different issues, then it is expected that the number of audit
findings will increase with a new auditor.

ILLINOIS STATE AUDIT ACT
The State of Illinois requires all of its agencies to be audited annually under the Illinois State Audit
Act. This Act was initially passed in 1957 and created the Department of Audits and the Legislative Audit
Committee. In 1977, the increase in the number of audits needed and the time constraints of the Auditor
General’s office prompted an amendment to the Act to allow for the hiring of special assistant auditors.
Special assistant auditors are external, independent certified public accountants hired by the Illinois Audit
General to conduct financial and compliance audits of the state agencies. Currently all the state universities
are audited by public accounting firms reporting to the Auditor General.

The hiring process is conducted through a bid process and is mandated by the Illinois Procurement
Code. The bid process reduces the impact of audit costs and fees on the due diligence performed during the
course of the audit cycle. Any fees paid to the audit firm are set before any work begins, and the audit firms
must keep the bids low in order to obtain the universities as a client. Additionally, the rotation program
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specifies a six year maximum for audit services from one individual audit firm; therefore the rotation schedule
is generally set at the time the bid is accepted.
An important distinction exists between the state audits and corporate audits. The Illinois Audit Act
specifies that the audit workpapers prepared by special assistant auditors are the property of the State.
Therefore, newly hired audit firms have complete access to the details of previous audit findings.
Accordingly, the start-up costs of the new audit firm may not be as high as those incurred if mandatory audit
firm rotation was required for public company audits.
SAMPLE
The sample consists of the nine public universities governed by the State of Illinois. The State of
Illinois issues Report Digests summarizing the results of each audit by the number of findings, a brief
description of the most significant findings, and the number of repeat findings. The most recent twelve years
of Report Digests were obtained from the Illinois Office of the Auditor General for each of the nine
universities. The Report Digests from fiscal years ending June 30, 1994 through 2005 were examined yielding
a total of 108 audit-years.
In this time period, there were thirteen full audit cycles to compare amongst the nine universities.
Although a rotation policy is set for every six years, there were four cases where the cycle was only four
years. This was done to establish a staggered rotation schedule across universities to ease the burden of the
Illinois Auditor General=s coordinating the bid process for all nine universities in the same fiscal year.
Fourteen different audit firms are represented.
RESULTS
The data are analyzed in two phases. First, the behavior of the auditor during the audit cycle is
examined, and then the behavior of the predecessor and successor auditor is contrasted.
During the Audit Cycle
The mean number of findings and the number of repeat findings is shown on Table 2. As the table

shows, the number of both findings and repeat findings decreases over the course of the audit cycle.
Matched-pairs t-tests determined that the difference between the findings in the first and last year of the audit
is significant. For findings, the t-statistic is 2.52, (p-value= .013), and for repeat findings it is 2.11 (p-value=
.028). The number of findings goes down over the course of the audit cycle.
Next, we investigate whether the size of audit firm contributes to the magnitude of the difference.
Firms were divided into the national firms and smaller firms. (There were not enough observations to classify
Big 4 as a group.) The general linear models technique was conducted contrasting the number of audit
findings by audit size and year of audit. When all six years are included, the model is not significant (Table
3).
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Table 2: Findings over Life Cycle of Audit
Year Findings Repeat Findings
1 7.85 3.31
2 6.15 2.08
3 5.56 2.33
4 4.56 2.22
5 4.77 1.46
6 3.08 1.08
Table 3: Audit Findings Across All Six Years
General Linear Model Results
Source DF Sum of Squares Mean Square F-Value Prob of F
Audit Size 1 27 27 1.19 .28
Year 5 165 33 1.44 .22
Model 6 192 32 1.4 .23
Error 63 1,446 23
Correct Total 69 1,638
However, when only the first and last year of the audit are contrasted, the year is significant even after
controlling for auditor size (Table 4).
Table 4: Audit Findings in the First and Last Year of Audit

General Linear Model Results
Source DF Sum of Squares Mean Square F-Value Prob of F
Audit Size 1 1.94 1.94 .07 .79
Year 5 148 148 5.41 .03
Model 2 150 75 2.75 .09
Error 23 629 27
Correct Total 25 778
The results indicate that near the end of the audit firm rotation cycle, fewer findings are disclosed.
The may be the result of a fresh look at the beginning of the cycle and/or systematic improvements over the
course of the audit, or it may be that auditors become less rigorous as the audit nears termination.
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Audit Change Years
Next, we examine the behavior of the successor auditor relative to the predecessor auditor. If it were
the case that the new auditor brings a new perspective to the audit, we would expect more audit findings by
the new auditor. On the other hand, if clients improved processes over the course of the prior audit, then the
new auditor may not have additional audit findings. With regard to repeat findings, we would not expect the
same relationship. Repeat findings should go down or remain the same as the auditor changes.
The results of t-tests contrasting the findings before and after the auditor change are shown in Table
5. There were twenty auditor changes over the period investigated. Of this group, the average number of
findings the year before a change was 4.95 while the number cited by the new auditor was 6.45, which is
significant. Additionally, there is no significant difference in the repeat findings across the two groups.
While this research does not attempt to evaluate the merit of the specific audit findings, since the number of
findings does increase significantly in the year of the change, the results suggest that the new auditor brings
a different perspective to the audit.
Table 5: Difference between Predecessor’s and Successor’s Number of Findings
(20Changes)
Mean # of Findings Mean # of Repeat Findings
Findings Before Change 4.95 1.75
Findings After Change 6.45 2.20

t-test 2.17 .93
two-tailed p-value .04 .36
The type of replacement auditor is tested next. The difference between the number of findings in the
last year of the predecessor auditor and the first year of the successor auditor was computed. Universities
changing to small auditors were contrasted to those moving to large audit firms. As shown in Table 6, the
number of findings increases in the first year when a large auditor is appointed, though the difference is
marginally significant (p=.07). It does not appear to make any difference if the prior auditor was large or
small (Panel B). The number of audit findings increases if the new auditor represents a large firm.
Table 6: Mean Difference between Predecessor’s and Successor’s Number of Findings
Partitioned by Auditor Size
(20 Changes)
From Small Auditor From Large Auditor Overall Mean
To Small Auditor 1.67 (N=6) 33 (N=6) .67
To Large Auditor 5.50 (N=2) 1.83 (N=6) 2.75
Overall Mean 2.63 .75
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Table 6: Mean Difference between Predecessor’s and Successor’s Number of Findings
Academy of Accounting and Financial Studies Journal, Volume 13, Number 3, 2009
Panel A – New Auditor is Large Auditor?
Yes (N=8) 2.75
No (N=12) .67
t-test 1.53
one-tailed p-value .07
Panel B - Stayed with Same Size Auditor?
Yes (N=12) 1.75
No (N=8) 1.125
t-test .38
one-tailed p-value .36
LIMITATIONS BASED ON NATURE OF SAMPLE
The findings of the auditors are systematically different over the life cycle of the audit. While the

State of Illinois provides an environment in which to examine mandatory audit firm rotation, some caveats
must be noted. For example, the audit workpapers are the property of the State and the subsequent auditor
has full access to those documents. This may decrease inconsistencies between audit findings of different
auditors. The availability of prior workpapers should increase the continuity during the audit change and may
be something to consider requiring if audit firm rotation should become mandatory for corporate audits.
In addition, the bid process may impact the auditor’s behavior. The audit fee for the entire audit cycle
is established at the time the bid is accepted. Also, the lowest bid must be accepted. This may impact the
hours devoted to the audit which may be reflected in the audit findings. In this bid environment, it is unlikely
that auditors would low-ball in the first year with the intent of increasing fees in subsequent years. Even if
mandatory audit firm rotation was implemented for corporate audits, these restrictions would probably not
be integrated. Therefore, in corporate situations where fees could vary each year, the pattern of audit findings
may differ from that reported here.
CONCLUSION
In a situation where audit firm rotation is required at least every six years, this research indicates that
audit findings decrease over the course of the audit. This corresponds to the results of prior research that
found higher quality audits in the earlier years, but contradicts the results of studies using discretionary
accruals as a proxy for quality. The current study also examined the final phase of an audit where audit firm
rotation is mandatory. The number of findings is significantly lower in the last year of the audit relative to
the first year. Finally, we contrast the findings of the prior auditor with those in the year of the change. Audit
findings increase especially when the new auditor is a large audit firm.
Additional agencies need to be examined and more research is necessary to further identify the
advantages and disadvantages of audit firm rotation. Also, by examining other states, it may be possible to
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identify differences between mandatory versus unscheduled auditor changes for state supported agencies.
Other states also have different laws regarding the custody of workpapers, and this may be a fruitful area of
investigation. However, the results of this study suggest that audit firm rotation may be beneficial. While
we did not investigate the quality of the audit findings, it seems the replacement auditors provide a fresh look
at the audit since they identify new issues for the client to address.
REFERENCES

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Jennings, M. M., K. J. Pany, and P. M. J. Reckers (2006). Strong Corporate Governance and Audit Firm Rotation:
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